Why the proxy access rule decision is a loss for activist hedge funds

August 02, 2011

Undoing the damage may prove difficult for the SEC.

By Christopher P. Davis

The recent proxy access rule decision delivered by the U.S.
Court of Appeals for the District of Columbia was a
comprehensive rebuke to the SEC. Judge Ginsburg’s
decision in
Business Roundtable v. SEC could be a death warrant for a
rule that would have allowed eligible investors to cheaply and
efficiently get their suggested candidates elected to public
company boards of directors. The SEC rule that was shot down by
the court would have allowed an investor to propose the
election of at least one director, but never more than 25% of
all directors, if that investor held at least three percent of
a company’s outstanding shares for at least three
years. Not every hedge fund would see the proxy access rule as
a tool of choice, but for those hedge funds meeting the
eligibility requirements, a potentially important and
relatively inexpensive activist tool is now on life support
unless the SEC can find a way to undo what the court has
done.

Read narrowly, the Business Roundtable decision finds that
the SEC failed (rather miserably, it would seem) to meet its
burdens under the Administrative Procedure Act to consider the
proxy access rule’s "effect on efficiency,
competition and capital formation." The court found repeated
examples of the SEC having been arbitrary, capricious and
illogical or inconsistent in its cost-benefit
analysis—which the court goes out of its way to note
is not the first time that the SEC has failed before the court
in its rulemaking duties. The completeness of the Business
Roundtable’s victory and the SEC’s
defeat is telling, with the court striking down the rule as it
applies to both public companies and investment
companies.

What may be most interesting for activist hedge fund managers,
however, are the factors the court never considered and the
unspoken assumptions the court seemed willing to make.

For instance, the court found that the SEC "failed to
appreciate the intensity with which issuers would oppose the
nominees" suggested by qualifying shareholders, while accepting
plaintiff’s figures that proxy contests would cost
those companies (and, by extension, their shareholders) between
$4 million and $14 million for larger public companies and
between $800,000 and $3 million for smaller companies. Not
once, however, did the court consider the cost savings to
qualifying shareholders in avoiding proxy contests against
companies that would otherwise squander their
shareholders’ money in opposing quality nominees
suggested by someone other than its nominating committee.
What’s more, the court seems to uncritically
accept that because boards are willing to spend such large
sums, the SEC must build even the most excessive examples of
this behavior into its cost-benefit calculations in trying to
justify the rule. It’s unclear whether the SEC can
realistically satisfy such an artificially high hurdle.

In another instance, Judge Ginsburg spends considerable time
focusing on minority shareholders who may act out of special
interests not shared by all investors, particularly labor
unions that might use the rule as leverage to gain wage
concessions. Yet the court assumes that boards act from pure
motives, and never considers that they may have their own
territorial reasons for opposing nominations under the rule
while wrapping themselves in the banner of fiduciary duty and
the business judgment rule. Likewise, the court never considers
that minority investors have no fiduciary duties to other
shareholders and are supposed to be acting in pursuit of their
own best interests, which in the case of hedge funds mean the
interests of their investors, whose interests may be frustrated
by an incompetent or entrenched public company board.

In finding fault with the SEC’s cost-benefit
analysis, the court also latches on to a study provided by the
plaintiffs purporting to show that in the two years following
the election of so-called dissident directors to board seats,
those companies underperformed their competitors by 19% to 40%.
But the court never considers that it is companies with weaker,
underperforming boards that typically face proxy contests in
the first place, and that where control is not obtained by the
activist, as would have been the case under the rule, the
shareholder friendly directors simply don’t have
the numbers on the board to bring prompt, wholesale
improvements. In other words, holdover directors from the old
regime can still serve as a drag on company performance, as
every activist knows.

It will take an impressive display of skill for the SEC to
reverse the downward trajectory of the rule at an en banc
rehearing or on an appeal. Starting from scratch on a new rule
would be time consuming, and it remains unclear whether the SEC
can bear the burden the court demands of it, especially in the
face of inevitable opposition from emboldened, well capitalized
and litigious industry opponents such as the Business
Roundtable and the Chamber of Commerce.

Ultimately, it may take an act of Congress to bring greater
board access to minority shareholders unwilling or unable to
spend a king’s ransom to get representation on the
board of a public company willing to adopt scorched earth
tactics to protect its nominating privileges. Given the
political capital Congress recently expended on the Dodd-Frank
Act, it is difficult to believe that this will be a priority on
Capitol Hill anytime soon.

Christopher P. Davis is a partner and head of the investor
activism practice at New York law firm Kleinberg, Kaplan, Wolff
& Cohen.